Does YiChang HEC ChangJiang Pharmaceutical (HKG:1558) Have A Healthy Balance Sheet?

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. As with many other companies YiChang HEC ChangJiang Pharmaceutical Co., Ltd. (HKG:1558) makes use of debt. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.

Our analysis indicates that 1558 is potentially overvalued!

What Is YiChang HEC ChangJiang Pharmaceutical's Debt?

The image below, which you can click on for greater detail, shows that at June 2022 YiChang HEC ChangJiang Pharmaceutical had debt of CN¥3.56b, up from CN¥3.09b in one year. However, it also had CN¥859.1m in cash, and so its net debt is CN¥2.70b.

How Healthy Is YiChang HEC ChangJiang Pharmaceutical's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that YiChang HEC ChangJiang Pharmaceutical had liabilities of CN¥3.97b due within 12 months and liabilities of CN¥852.1m due beyond that. Offsetting these obligations, it had cash of CN¥859.1m as well as receivables valued at CN¥765.3m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥3.20b.

This is a mountain of leverage relative to its market capitalization of CN¥4.83b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

While we wouldn't worry about YiChang HEC ChangJiang Pharmaceutical's net debt to EBITDA ratio of 4.6, we think its super-low interest cover of 1.1 times is a sign of high leverage. It seems that the business incurs large depreciation and amortisation charges, so maybe its debt load is heavier than it would first appear, since EBITDA is arguably a generous measure of earnings. It seems clear that the cost of borrowing money is negatively impacting returns for shareholders, of late. One redeeming factor for YiChang HEC ChangJiang Pharmaceutical is that it turned last year's EBIT loss into a gain of CN¥280m, over the last twelve months. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if YiChang HEC ChangJiang Pharmaceutical can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Over the last year, YiChang HEC ChangJiang Pharmaceutical saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

On the face of it, YiChang HEC ChangJiang Pharmaceutical's interest cover left us tentative about the stock, and its conversion of EBIT to free cash flow was no more enticing than the one empty restaurant on the busiest night of the year. But at least its EBIT growth rate is not so bad. Overall, it seems to us that YiChang HEC ChangJiang Pharmaceutical's balance sheet is really quite a risk to the business. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. For example, we've discovered 1 warning sign for YiChang HEC ChangJiang Pharmaceutical that you should be aware of before investing here.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.